Looking for the right loan could be a daunting task, especially if you don’t understand the basic concepts needed for comparison. Such as the difference between the APR and interest rate. Thus, when shopping for loans, one (but not the only) important issue that you must understand is the APR and interest rate difference. APR stands for annual percentage rate. It is a common misunderstanding that the total loan expenses are only the interest rate for the principal amount. Thus, there might be a difference between your calculation about the total loan expense (taking into account only interest rate) and the calculation of the loan cost given to you by the bank (considering all loan-related costs).
APR and interest rate difference
If you understand the difference between the annual percentage rate and interest rate, you will avoid any uncomfortable situation when applying for credit. Even more importantly, you will be able to make a more informed and concise decision about the selection of a lender which will offer you a loan with the lowest level of expenses. You can find APR and interest rate explained within the following lines.
- Interest rate (or nominal interest rate) – is your annual cost for the loan, stated as a percentage of the original (principal) loan amount. But keep in mind that this is not the sole cost for you. This is only the price you pay for the principal loan amount. The interest rate does not include any other fees you pay for the loan.
- Annual percentage rate (APR) – while the interest rate can be considered the “direct” cost of the loan, APR represents the entire cost of the loan, including many lending fees that you might be charged with. It consists of two primary components: the interest rate and fees charged by the lender. Some of the fees that could be associated with your mortgage and are included in the APR are mortgage insurance, closing costs, loan origination fees, etc. APR is also stated in percentage. Thus, keep in mind that actually, the APR is representing the total cost of your mortgage, not the interest rate. APR is always greater or at least equal to the nominal interest rate (interest rate), of course, as with everything else, there is an exception from this rule.
You should be aware that you can not make a complete and valid comparison between different mortgages based on the interest rate only. It will give you invalid results because one mortgage could have lower interest than other mortgages, but it can have a higher APR due to higher fees. You should not take for granted that the interest rate is not important, and thus, not take it into account when shopping for a loan. Instead, you should be aware that the interest rate does not present the full cost of the loan. Hence, to find the total cost of your loan and decide about the loan you will apply for, you should make your decision based on the APR.
You should know that according to the Federal Truth in Lending Act, every consumer loan agreement should disclose the APR. Thus, your lender should inform you not only about the interest rate but also about the APR on your loan. If you want, you can calculate the loan APR on your own using an online calculator. If you use an online calculator to find the APR on your desired loan, when you go to your lender, please do not become the “know it, everything client.” You should know beforehand that there might be differences in the APR from your calculations and the APR provided by the possible lenders where you will apply for a loan. The discrepancy could also appear in the APR calculated from various lenders. The reason is that, although there are some universal fees charged by the lenders, there are also lender-specific fees. This is, in a sense, that one bank might charge you a fee that other banks will not. Thus, aside from your calculations, the smart thing would be to ask the amortization schedule for the desired loan from different banks and lenders in general, where you could apply for the loan. All relevant information should be stated on the amortization schedule, thus, among other things, you could easily spot the APR and interest rate difference.
As mentioned earlier, to calculate the APR, you must know the fees taken into account for APR calculation. Afterward, you should add all these fees to the principal amount of the loan. By doing this, you will get a new loan amount. Thus, you are performing amortization of the fees over the loan repayment period as if they are additional payments.
Although APR is a better option (concerning interest rate) when comparing different loans, it does bear a certain drawback. The problem with APR is the type of fees included in the calculations. Even though there are some fees typically included in the calculation of APR, different lenders might charge different additional fees for various loans. But this drawback can be eliminated by gathering information from the lenders about the fees included and excluded in the APR calculations.
Understanding APR and interest rate difference is essential when shopping for loans (personal loans, car loans, equity loans, mortgages, etc.). APR is useful because it incorporates the lenders fee that you should pay in the overall amount of the loan. But, you should be aware that although APR is easing the comparison process, it does have its drawback. For instance, some fees are not included in the APR calculations. Thus, to compare different loans, you should always ask your lender to give you a list of all fees included in the APR, as well as a list of fees that should be paid but are not included in the APR.